Chesapeake: 'Third Scenario' Could Be Huge For Investors

In early June, Chesapeake (NYSE:CHK)announced that one of its wells in the Anadarko Basin, in what is known as the Hogshooter formation, is producing more liquids than any other single well in the company's history. According to Chesapeake, the well, Thurman Horn 406H, produced 5,400 barrels of oil, 1,200 barrels of liquid natural gas, and 4.6 million cubic feet of natural gas in its first eight days of production, which taken together is equivalent to 7,000 barrels of oil. Thurman Horn 406H is only the second horizontal well Chesapeake completed on the Hogshooter, which is a part of Chesapeake's 30,000 acres on the Anadarko Basin. The company has two further drills "waiting on completion" according to the company's press release.

Chesapeake's other complete well on the Hogshooter, Meek 41 9H, produced 1,400 boe, in its first 27 days of "stabilized production", according to Chesapeake. This is substantially lower than what is reported from Thurman Horn 406H, though the wells are only spaced at five miles. This makes it likely that Chesapeake's announcement does not indicate a new discovery, but a small pocket on a formation that is already known. Though the results from Thurman Horn 406H are impressive, this alone will not be enough to move Chesapeake from a natural gas producer to an oil producer, and certainly will not save Chesapeake from its current debt woes. Chesapeake CEO Aubrey McClendon put a more positive spin on the announcement, saying "…this new Hogshooter development area should further enhance our growing liquids production, which we expect will have transformational effects on our company's operational and financial performance in the years ahead."

Looking at other operating results on the Hogshooter formation shows that McClendon is ahead of himself. SM Energy (NYSE:SM)reports production in the Lower Hogshooter Wash can hit 2,000 bopd plus 4 mmcfgpd, but there is an enormous range. Chesapeake's #1-6H McConnell well completed in March 2011 reported substantially lower production, at 544 bopd, 843 mcfgd, and 272 bwpd. Apache (NYSE:APC) also showed a range, with its #1-23H McRee reporting 729 bopd, 1,547 mcfgd, and 1,740 bwpd, but its nearby #1-5H Edler reported double this production at 1,588 bopd, 3,019 mcfgd, and 802 bwpd. Just a mile from Apache's #1-5H Edler, Cimarex (NYSE:XEC)reported 654 bopd, 1,692 mcfgd, and 332 bwpd from its #1-4H Kephart. These results indicate to me that Chesapeake would be foolhardy to stake itself on Hogshooter, though competitor QEP Resources (NYSE:QEP) is on a growth spurt driven in part by its Granite Wash acreage.

Thurman Announced to Offset Moody's?

The Thurman Horn 406H announcement came hours after analysts at Moody's released a statement indicating that Chesapeake must sell at least $7 billion in assets to avoid falling into a breach of covenant with one of its lenders. The statement expressed doubt that $7 billion would cover Chesapeake's "covenant compliance for its revolving credit facility…and the company would still face a significant funding gap in 2013." Moody's suggested that $10 billion or more in asset sales might gain Chesapeake a steadier foothold, and ameliorate the risk of further credit downgrades.

Moody's downgraded Chesapeake's outlook to negative in early May, noting that the decision "reflects the escalating execution risk of Chesapeake's plan for funding its large capital spending budget, rising leverage metrics and accompanying liquidity concerns...we are also concerned that the company's leverage metrics could remain elevated or continue to increase." The analyst notes on "rising leverage metrics" were release just two days before Chesapeake announced a $3 billion loan agreement with units of Goldman Sachs (NYSE:GS) and Jefferies Group (JEF), which was increased to $4 billion days later.

McClendon has a history of overly optimistic predictions, which Chesapeake's shareholders are finding increasingly alarming as Chesapeake's star fades. His confidence in the marketability of his company's Permian assets, his prediction that natural gas prices will reach $5 by 2014, and his comments that the now-on-hiatus IPO of Chesapeake Oilfield Services would debut to a value between $5 and $7 billion are among the statements that have shareholders concerned McClendon is out of touch with the realities of Chesapeake's financial picture. Looking in particular at the Chesapeake Oilfield Services spin-off, I think that Chesapeake was relying on the IPO to make up part of its funding shortfall, and failed spectacularly. Six months after McClendon's original comments, the value of the IPO dropped to $862.5 million - about 85% below McClendon's mid-range - and a month later, Chesapeake took the IPO off the table until at least 2013. The cancellation of the IPO passed quietly amid revelations about McClendon's financial tangles and his company's ever-widening cash shortfalls, but it shows how deeply troubled Chesapeake is.

Outlook

Chesapeake's potential partners and purchasers now have negotiating power over the struggling company, which sets up two simple scenarios for McClendon and top management. In the first scenario, Chesapeake is able to pull off its planned asset sales and accumulate the joint ventures it needs for cash for development , but at a substantial discount to what it is seeking (and possibly, a discount to what it actually needs to survive). In the second scenario, Chesapeake refuses offers that are less than what McClendon is publicly announcing as the price of cooperation, turning away any potential purchasers and partners, which leads to the scenario that Moody's noted in its latest analysis: A steady cascade of loan accelerations after one default, which could send Chesapeake deep into the red and off the big board.

I am holding out for a third, more complex scenario, which could be a windfall for shareholders. In this scenario, Chesapeake is able to sell enough acreage to simplify its balance sheet but not enough to remain viable, prompting a merger with one of the major independents. Those who purchased Chesapeake stock when it was riding high at $28 and up might not receive satisfaction from the deal, but investors who spotted an opportunity when Chesapeake dropped to sub-$20 levels and its price to book dropped to 1.0 and lower certainly would. This might also be the most likely scenario, as I think Chesapeake's board and shareholders would be inclined to approve such a deal if the alternatives are closed off. For this reason, I think that as it stands now, around $16 and heading up with a price to book of 0.8 and a forward price to earnings of 8.4, Chesapeake is a risky buy, but a buy and accumulate nonetheless.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.